How Will The EU’s Revised Excise Taxes On Cigarettes Affect Consumption?

The European Union (EU) contributes ~28% to Philip Morris International’s (NYSE:PM) consolidated net revenues and is the most profitable division of the company with adjusted EBIDTA margins of over 50%. The division contributes over 25% to the company’s total value by our estimates.

However, Philip Morris’ EU operations have been under pressure over the past few years due to the growing presence of illegally traded cigarettes in the region amid weak macroeconomic conditions. Not only this, taxes on cigarettes in the region at around 70% of the weighted average selling price are among the highest in the world. Here we take a look at the implications of a revision in these taxes, which is scheduled to be implemented next year on the consumption of cigarettes in the region. [1]

According to a law that defines excise taxes on tobacco products in the EU, member states have to apply a specific “per unit” excise duty on cigarettes and a proportional excise duty that is calculated on the basis of the weighted average retail selling price (WAP). Under the current taxation scheme, the overall minimum excise duty stands at 57% of WAP. It also entails an absolute minimum excise tax of EUR 64 per 1,000 cigarettes, irrespective of the retail selling price. However, EU countries that levy an excise duty of at least EUR 101 per 1,000 cigarettes on the basis of WAP need not comply with the 57% requirement. Additionally a value added tax (VAT) of around 13% increases the total tax on cigarettes to more than 70% of the average retail price. [2]

According to a planned revision of the current taxation scheme, the overall excise duty on cigarettes shall represent at least 60% of WAP from January 1, 2014. And the absolute minimum excise tax per 1,000 cigarettes shall not be less than EUR 90 per 1,000 cigarettes irrespective of the retail selling price. However, member states that levy an excise duty of at least EUR 115 per 1,000 cigarettes on the basis of WAP need not comply with the 60% requirement. A few countries including Bulgaria, Estonia, Greece, Latvia, Lithuania, Hungary, Poland and Romania will be allowed a transitional period until 31 December, 2017, in order to reach the required amount of excise duties. [2]

Potential Impact

According to the latest available excise tax numbers, the average excise tax across all the member states is around EUR 128 per 1,000 cigarettes or approximately 63% of WAP. This is more than 25% higher than the excise tax floor of EUR 101 per 1,000 cigarettes suggested by the directive. [1] The fact that actual excise taxes are much higher than the minimum required levels is not surprising, as the taxation of tobacco products is an important source of revenue for the member states. Total tax collected by the member states from the tobacco sector (including VAT) was more than EUR 100 billion in 2012. More than 80% of this came from cigarettes. [3]

Therefore, assuming that the revised minimum excise tax levels would also be exceeded by similar proportion, we estimate the average selling price of cigarettes in the EU to increase by ~10%. Based on the results of a study conducted to estimate the sensitivity of cigarette consumption to price increases in Europe, we estimate the scheduled revision in excise taxes to result in around 5-7% decline in the demand for cigarettes in the region. [4]

We expect the isolated impact of this measure on the profits of Big Tobacco companies to be minimal as a revision in excise taxes and the related decline in cigarette consumption would be mostly offset by price increases in the long run. However, there could be other implications such as higher consumption of other tobacco products, which are taxed significantly less compared to cigarettes. Over the last decade, the consumption of roll-your-own tobacco in the EU has increased more than 40% even as the consumption of cigarettes has declined by ~25%. [5] Furthermore, it could also lead to an increase in illegal cigarettes trading, which is already a huge cause of concern for both the companies as well as the governments. (See: Philip Morris’ Potential Downside From The EU’s Illegal Cigarette Trade)

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